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The idea for this podcast was suggested by listeners who want to be better informed when it comes to the accounting aspect of their small business. So, based on that suggestion, in this podcast we speak with a CPA who works with small businesses to get his expert answers to questions that were submitted via Facebook by our listeners.

Hi, and welcome to the Small Food Biz Podcast. I am Jennifer Lewis and in this podcast series we are focusing on the issues food entrepreneurs face and the questions you have as you work to accelerate your business’ growth. Accounting tends to be one of those areas where food entrepreneurs have a lot of questions so I’ve asked Tim O’Rourke to join us today to answer some listener questions that came in via the The Small Food Business Facebook page.

Tim has been an accountant for the past six years and specializes in working with restaurants and small food businesses. Tim has worked with owners and managers who are opening restaurants and starting food businesses all the way through their life cycle to preparation as they prepare to be sold as well as performing due diligence for investors who are looking to make acquisitions. You can find our more about Tim at www.orderupprofits.com and as always there will be a link to his website from the Small Food Business page.

Before we beginning today, though, I do want to set forth a little bit of a disclaimer and that is that what we are talking about today when it comes to accounting topics, we are looking at it from a very high level. As with anything tax and accounting related if you have any questions you need to consult with a CPA who can help look at your overall financial picture and provide you with advice specific to your situation. With that disclaimer out of the way, Tim, thank you so much for taking the time to join us today. Really appreciate it.

Timothy:

Sure, I’m glad to be here and I can’t wait to get started and answer some questions.

Jennifer:

Let’s start with a really basic, or it sounds like it is a basic question but it’s really a very critically important question, and like I said all of these questions came in through listeners. The question is, what exactly is cost of goods sold? You know, if you are looking at a profit and loss statement you see that kind of separated out? What, from a food entrepreneur’s standpoint, you know, what is it, what sorts of items and expenses go into that and why is it so important that it’s broken out from the rest of your expenses?

Timothy:

Sure, so the first part of your question costs of goods sold is any of the food that you buy to sell on to customers, so your raw materials. What’s important about that is you can directly measure one of your most important costs. What you want to do is track verse your sales for, say in a restaurant when you sell food you want to look at how much the food is costing versus how much money is coming in, because it gives you a very good ratio to track how efficiently you are running.

Then it can also tell you a lot of things about your business like are people stealing from you? In restaurants, you see that a lot when a bartender will pour a free drink for people and it drives up your cost of goods sold. You can use a ratio analysis to see that happening. What you would do is look at the cost of sales percent and you can track it and if liquor for a bar is over seventeen or eighteen percent you can tell that someone’s probably giving away free drinks or actually walking out of the back of the building with a bottle of liquor.

Jennifer:

Is there, you mentioned kind of seventeen, eighteen percent? Is there a place where folks can find where those ratios are? Are there kind of industry standard ratios or is this just because you’ve been in the industry long enough these are things that you know and recognize?

Timothy:

I don’t think that there’s really published industry rates. I know that CPA firms track these cost amongst all their clients so that they kind of come up with benchmark guides.

Jennifer:

Okay.

Timothy:

If you have an accountant they do your taxes, a really good thing for you to do is ask them to give you some benchmarking data and to look at cost of goods sold and then also for restaurants, cost for cover of what your costs are. For people who aren’t familiar with the term cover, that’s just a person who walks into a restaurant. You want to see for a lot of the direct operating supplies like plastic wrap, or aluminum foil, or to go boxes, is your cost per person, or cost per cover, staying the same or going up? You can use that then to see how efficiently your management is operating but then also if it’s time to start looking for new suppliers because after you’ve been someone’s customer for a year or two they might start to drive the prices up slowly but surely and you don’t really notice it without doing that kind of financial statement analysis.

Jennifer:

You know I appreciate you bringing up the idea of not just having your accountant do your taxes but asking them to kind of be a little bit more of a partner with you and help you understand the profit and loss statements, help you understand the benchmarks because I do think for a lot of food entrepreneurs we don’t come into this with an accounting background and sometimes those numbers can seem either scary to get into or they can just, you know, we sort of, “Okay great, we’ll write our check, we’ll pay our taxes and we’re done.” You’re right, those numbers tell the story behind your business.

Timothy:

Sure, and I actually got into accounting because I really wanted to understand business and accounting is the language of business. There was a quote that I read in Business Daily, I think, or I forget the publication but it was from Warren Buffet and he said, “If you want to become a savvy investor, you need to learn as much as possible about accounting.” That’s actually kind of why I got into it. I was working for a very large Fortune 250 company and I realized that the things I was doing on the operations side weren’t necessarily driving the decisions being made and I asked for some advice on how to figure that out and it turned out accounting was what I was missing and what I needed to learn to understand what was going on kind of behind the scenes and in the boardroom and that kind of thing.

Jennifer:

I’m laughing because as a bit of background for those who are listening, my husband is in financial services and when I was going through my MBA program he basically sat me down and said you have to take cash accounting, you need to understand cash accounting if you are going to be an entrepreneur and probably like many people listening I fought it for a little while because accounting doesn’t seem that much fun if that’s not kind of where your passion lies. I will say that I came out of my MBA program and said, yep, that was from an entrepreneurial standpoint, that was the number one class I took. Which actually brings me to my next question, can you explain at a high level the difference between cash versus accrual accounting? What are the key questions a food entrepreneur should be asking an accountant when trying to decide between the two?

Timothy:

Let me preface that with a caveat, I would never tell your accountant what accounting treatments to use.

Jennifer:

Okay.

Timothy:

You guys as a paying client shouldn’t want to. You should, I mean you are paying a lot of money probably for a CPA, you should tell them to do it the most beneficial way that they can. Now, I can tell you what you will probably want to do is look at accounting on an accrual basis and then also track your cash flow. The difference between accrual and cash basis accounting is for cash basis you earn income when you receive cash and you gain the expense, or acquire an expense when you pay the cash out. That can be very misleading because you’re not really measuring what’s going on in your business, you are just measuring when you write checks and when your customers or clients give you checks.

Accrual accounting measures the amount of expense that is required to earn the income you earn during a set period of time. That’s very important when you are looking at profitability and even the cost of goods sold and things because if you buy a lot of food to sell all at once and then you sell it over you know many months, using cash basis accounting it’s going to look like you’ve lost a lot of money upfront and then you made a lot of money all year but what you are really doing is just paying for it upfront and making money as you sell things.

Jennifer:

It sounds like, and certainly correct me if I’m wrong, but also then for folks who are selling wholesale and they might be selling on net terms where maybe they’ve bought in all the ingredients, they’ve made all the product within say one month we’ll just say time frame but they’re not going to be paid for sixty days. With accrual accounting, you would at least be able to tie the payment back to the cash that was spent to produce the product, right?

Timothy:

That’s exactly right, that’s exactly right. That’s what you are doing, you are tying an expense to the income with accrual accounting.

Jennifer:

Okay. Again, very good to know. This, by the way, this conversation, folks who have followed the website for awhile or if you’ve ever taken any courses or listened to webinars, you’ll always hear me say that I think that an accountant it the first hire that you need to make for your business. Now, by that I mean they’re a third party so you know somebody that you are going to be working with not necessarily a hire into your business but I just feel like it’s very hard unless you come from an accounting background yourself. It’s very hard to run a strong, successful small business without having an accountant that you can turn to with questions like this.

Timothy:

Yeah, and I would follow up on what you said about finding an accountant that does more than just write your tax returns and then sign them for you. There’s kind of a difference in the accounting world, there’s like, I think they say there’s like three hundred types of careers you can have as an accountant. You really want to find someone who has a background in your industry and a background with small business, if you are just starting out in entrepreneurialship, who understands the hurdles you are going to face and the industry you are going into so that they can not only do the benchmarking but there’s a lot involved and I tend to focus on restaurants because in Chicago we’re having a restaurant and craft cocktail bar boom right now so they are opening like crazy.

It’s very important to know the systems they should set up financially so that they are covered, the insurance that they should have so that they are covered, the even you know vendors to work with who can deliver these things as cost effectively as possible. Whereas if you are just starting out you don’t know those things so you need to find professionals who have that experience and can help you get started because you are going to spend a lot of time kind of learning the tricks to the trade and not perfecting your product and not really focusing on getting product market traction. Which, as an entrepreneur, I imagine where your passions really lie and what you want to do.

Jennifer:

Yeah, absolutely, absolutely, so speaking from, another question that we have from a reader and this goes back to you know another reason you need to have the accountant that you can pick up the phone and call. We get, everybody kind of has these questions around what can you write off or not write off and how can you reduce your taxes. A listener wrote in and said, you know there’s an urban legend that it’s okay to take a loss on your business taxes for the first three years of being in business?

Timothy:

Yeah.

Jennifer:

Can you speak to this, I mean, is this something that you can do without raising red flags? Is there an acceptable level of loss that you can have? What, is this true or not?

Timothy:

You know there is, so what the deal is? I think that the person who wrote in I think they actually got the urban legend a little backwards and I think what the rule is, the general for the IRS in determining if something is a hobby or a business, is that it needs to be profitable three out of five years to be a business.

Jennifer:

Okay.

Timothy:

What that’s saying is the loss that you carry forward can be from two years and not three or the loss that you use against your day job can come to offset. It’s two years, two out of five that can be a loss, but I wanted to kind of caution readers about that kind of mentality because while I think you should find a professional tax guy who can help you find all the credits available not only as an individual and a business but specific to your industry. Something that I always tell people and I’ve said it a couple of times already is you really want to find someone who knows your industry because they are individual industry-specific tax credits and deductions that people just won’t know. For instance, I mentioned I work a lot with restaurants, there’s a FICA tip tax credit that saves restaurants thousands of dollars a year but most accountants don’t know about it.

There’s that but then also the acceptable level of loss is that you are going to have losses in the beginning and you’re going to kind of lose money for the first year or two but your goal really needs to be to make a profit and to be profitable. This is one of the questions where it’s so specific I don’t even what to throw out numbers because you really need to sit down with an accountant and look at your whole financial picture to say what would be a red flag or wouldn’t be a red flag when you are looking at this type of stuff. If you’re consistently running a business at a loss, you’re going to have to justify why it’s a real business as opposed to a hobby and something you are doing and trying to generate some deductions from your day job because if you are in business you are trying to make money.

Jennifer:

Yep.

Timothy:

Whereas if you are collecting wine and you are just collecting wine you’re going to always lose money because you are always buying wine, or something like that. I’ve seen people trying to write that off as a business and write off you know sixty thousand dollars worth of wine purchases a year, and after a while, it just doesn’t make sense because you are not selling any of it. It’s not a real business. I think that’s how I would approach that, you can always take your losses and there’s one other thing I wanted to say.

I know someone who is really into horse breeding and she didn’t like the food that she was buying for her horses so she started a company to make and market horse food, kind of like dog food. What she’s doing, and so she’s run a loss for more years than two, probably more than five, I’d have to go back and look, but she’s actively marketing the business, she’s actively trying to make money off of it. We do say that that’s a business and I think we’ve documented it appropriately to prove if it was ever questioned that it is a real business, it’s just not making money yet. It hasn’t caught on. There are, you know that’s again a conversation for you and your tax professional to have and to set up the documentation right because if you do the documentation right and you are trying to run a business you could probably get away with three, or four, or five years worth of losses at once.

Jennifer:

Okay, that’s good to know. I mean hopefully, nobody’s in that situation where they are running a loss for multiple years but it just still good to know that if you do think that you’ll find yourself in that position just to prepare in advance.

Timothy:

Yeah, that’s the key as with anything with taxes or any kind of paperwork that could be, you could be called upon to answer questions about years later, and with the IRS I think they are running eighteen months behind tax returns right now so they are not going to even really think about sending you a question for eighteen months.

Jennifer:

Oh wow.

Timothy:

That’s just what a friend of mine told me who happens to work for the IRS. I don’t know if that’s official or anything but you always want to have your paperwork prepared and have documented and even if you make notes, or write memos and put them in those little files so that you can remind yourself why you did things and you’d never hand it to an auditor but you want to have kind of a narrative of why you did something and how you justified it in case you can’t remember. I think you can go back six years in a tax audit so you need to kind of be prepared for that, especially with a business.

Jennifer:

I laugh because I’m thinking, I’m like I don’t even remember what I had for breakfast yesterday let alone what I was doing eighteen months ago or the decisions I was making six years ago.

Timothy:

Exactly.

Jennifer:

One of the things from a small business standpoint, I mean obviously we’ve talked a lot about working with a tax professional but at the same time small businesses are trying to save money. Do you find that there is value in a small entrepreneur or small restaurateur keeping up their own accounting books and then working with a tax professional for the other, for the actual filing of the taxes, and benchmarks, and help with the financial analysis? If so, do you have any recommendations on accounting software that food businesses, you know, that you’ve either seen or that you’ve used that you feel are good for small businesses?

Timothy:

Yeah, you can definitely keep your own books certainly until you reach a certain size of, I mean what’s the cottage industry laws for working out of your kitchen, twenty-five grand? I always kind of tell people within that range you can keep your books. You’re not really, there’s not that much you could do wrong that an accountant can’t go in and fix in a couple hours. I would you know certainly start out doing it yourself because it’s just cheaper and easier and you have other things to focus on besides finding a tax guy that you like, or you know a bookkeepers and accountants you can really like and build a rapport with.

That being said, I’ve heard that there’s two things you should always pay for in life. You should pay for a lawyer to write your will and you should pay for someone to file your taxes. Even as a tax professional and an accountant I have someone else do my taxes because I’m in it too much and I don’t want to be the last set of eyes to look at a decision or a judgement call and not have someone to bounce ideas off of and not kind of plan how I structure transactions or businesses. You know there’s no real value for me to just think about and do it as opposed to pay a couple hundred bucks and be able to bounce the idea off someone else.

Jennifer:

Yeah.

Timothy:

I would say, I guess to answer your question, I would to do the bookkeeping, just data entry, sure you can do that and if you stay on top of it go ahead. The only word of caution would be if you put it off for like you know eight months or a year they need to get out the shoe box and its time for taxes. You’re not really getting anything out of it and your books and your financial information can tell you a lot about your business that you wouldn’t see otherwise. If you stay on top of it, yeah, go ahead and do the bookkeeping. I would pay, I mean you could pay two hundred bucks I think and get the schedules and things prepared you need for a small business so I would just do that.

Jennifer:

Okay, what about, one question we had was the impact of inventory management on your business financials and the business taxes and then kind of the secondary part of the question that this person asked was is there any system that you know of that can specifically keep track of inventory movements in and out of different facilities and in and out of different kitchens?

Timothy:

Wow, good question, so purchasing inventory really has no effect on your financial statements or your profit and loss statement if you are an accrual basis accountant. If you are a cash basis accountant it can, you know, if you are using cash basis accounting and you are at the end of the year and it’s 12-31-16 you can buy all your inventory for the next year and essentially lower your net income for the year, you know? You can kind of play those games. I imagine, especially because we are talking about food businesses, you really want to focus more on having good raw materials that you want to sell your customers.

I would, you know, I think this is a good time to broaden the question a bit and I always get a lot of questions about how to defray tax costs and how to get tax income lower, or taxable income lower. I think that that’s an important question to ask and it’s important to think about but there’s different ways to do it and you can do it through long term planning and kind of planning the types of equipment you buy and when you buy equipment and when you take on new types of products, which then require large outlays of cash to get you know more equipment and more space and all that. Or, there’s the kind of things like buying more inventory at the end of the year where you might actually wind up hurting your business but you are paying less in taxes.

Jennifer:

Okay.

Timothy:

I think what you really want to do is focus more on really meeting the needs of a customer, of having great product and then realizing that in this country if you make income, you’re going to pay some tax. That’s just the way it goes. You want to minimize the tax paid, of course, but realize you know if you are making money you are going to pay tax. I always tell my clients they should want to pay a ton of tax because it meant they made tons of money.

Jennifer:

That’s what I was just thinking. I’m like, we can put a positive spin on this which is if you have a good tax professional working with you who is going to take all the credits necessary, you actually want to be paying a lot in taxes because that’s a really good thing for your business.

Timothy:

Exactly. Yeah, it means you made a lot of money. I forget what the highest tax bracket is for this year I think it’s forty percent or something but that means you made a lot of money if you are paying forty percent and that’s before all the write-offs, credits, and deductions. It’s a double-edged sword I guess.

Jennifer:

While we are kind of talking about this tax issue, this is a question I hear a lot both from readers and listeners and then also when I teach in-person classes. If you are using a home office, or a home kitchen, how much of a red flag is that if you are trying to use that as a deduction? Is that, I’ve always heard that’s one of those things that the IRS definitely kind of raises an eyebrow at and might look more closely at, or is it something that can be fairly easy to do, again with the disclaimer of you are not giving specific advice to somebody right now?

Timothy:

Yeah, I think it does raise a red flag but small entrepreneurs are the most audited class of business there are or at least it was a year or two ago. I think it’s now switched to millionaires and people with over seven figures of income. I’d go into this realizing that you are going to need to have good documentation, good tax advice, and be prepared for getting a letter asking for you know some questions. That said, a home office and a home kitchen do not necessarily raise red flags but you want to keep it all within reason. There are benchmarks and there are acceptable levels so if you say you know you paid five hundred thousand dollars for your in-home kitchen it’s going to raise a red flag and that’s very specific advice that each person would need to get from their tax professional besides kind of just the broad stroke of you should take it, you should document why you’re doing it.

I mean you can go even, you should know the square footage of the space that you are deducting from and come up with a ratio of the square space for your home office or kitchen versus your whole house. There’s going to be some questions about if you are using an in-home kitchen and you are also preparing all of your food that you eat out of it should it be claimed or not? The IRS wants the space to be dedicated to your business, so there’s a lot of questions around that that you should have a conversation with a tax professional who really knows your situation and will look at it.

Jennifer:

Really quickly, and the answer to this might just come down to it’s all about documentation but because we do have folks who are listening who are looking to start up cottage food or home-based food businesses in those states that it’s legal. What if they want to purchase something, like the new Kitchenaid Mixer they want to purchase for their home based business, how do they prove or have proof on hand that it is actually being used for their business even though their business is out of their home kitchen that they also bake their cookies out of?

Timothy:

Yeah, you also hit the nail on the head with it, you document it and you document it with the receipts and at the time you buy it you don’t wait until the day before the audit. You can even keep track of, like a log like you would keep track of in some large scale manufacturing operation, you keep logs of what’s made on machines. You can do stuff like that so that you are logging that you actually used it every week to make your cookies that you sold.

Jennifer:

Okay, okay. We’ve talked a lot about documentation can you scan this documentation or does the IRS still require you to bring in like paper copies of everything?

Timothy:

That is a great question that I don’t know the answer to. I do both. I scan it because if there’s a fire and everything goes up in flames you have something but I do keep all the paper copies and I think there’s something for having paper copies and having banker boxes that are filed neatly. When I was trained on how to go into an audit, I was told that some of it, if not a lot of it, is based on how you come across and being organized and having all of your things together and having good documentation proves a lot to the auditor that you really put thought into each thing you did so they are not going to just be wondering is it kind of slipshod kind of operation and you kind of guessed on a lot of your numbers. That you are prepared and then again, the documentation and notes to yourself to have the narratives and then, it goes a long way.

Jennifer:

I think the reality of, kind of to sum up what we’ve been talking about today, the reality is working with somebody you trust and taking the time to make smart decisions for your business. Looking at it both from a business strategic standpoint but also from the tax standpoint and how are you best going to serve your customer and best increase your revenue. I mean that all just, that’s all about careful preparation and taking the time to do it right.

Timothy:

Exactly.

Jennifer:

Tim, I know that we touched on a bunch of different topics today and again, I really appreciate your taking the time to talk us through some of this stuff. Accounting, like I said, is always one of those pieces that folks have a lot of questions about and I know you answered a bunch of questions for me. The number one being that I need to start talking to my accountant about benchmarking, so thank you. We very much appreciate that.

Timothy:

Sure, of course.

For more Small Food Business podcasts, click here. Do you have a topic you’d like to see covered on this podcast or would you like to share your entrepreneurial story? Feel free to email me at info (at) smallfoodbiz (dot) com.